An Introduction To Peer-to-Peer Lending

Having been around for a little under a decade peer-to-peer (P2P) lending is a relatively new option in the world of investible assets. These platforms help bring together borrowers and lenders in way that benefits both parties. Borrowers have the opportunity to take out loans at a lower fixed rate compared to what they would get through a traditional bank or consumer credit line. Investors benefit from these platforms by purchasing fractional shares of these loans (called notes) in $25 increments allowing them to diversify across a broad range of loans and borrowers with relatively small dollar amounts. and are two of the largest peer-to-peer marketplaces in the United States. Both claim high returns (relative to other forms of fixed income) and portfolio diversification as being among the primary benefits of investing in P2P notes.

Michael Kitces recently put together a detailed summary of the nuances and risks involved with peer-to-peer loans. Perhaps one of the greatest things to realize is that the borrowers seeking these loans are inherently experiencing some sort of financial distress (credit issues, poor cash flow, etc.) and are thus willing to take on loans that can have interest rates in excess of 30%! This should not be forgotten as at least some of these loans are likely to default and create a corresponding drag on returns to investors. Additionally the loans generated on these platforms are unsecured, leaving the lenders out of luck should borrowers default.

There is also a much larger risk that should be mentioned. Both Prosper and Lending Club are still relatively young, and there is at least some risk that the businesses themselves may face significant difficulties including bankruptcy. The consequences of such events are acknowledged and outlined in the prospectus documents for each company (see links below). Additionally, since these companies are so young, there is also a shortage of historical data to understand loan behavior through the various stages of a business cycle (e.g. defaults increasing during recessions). The loan data that is available dates back to 2009 and can be examined through NSR Platform with an easy to use comprehensive set of filters.

The process of purchasing newly issued notes would seem to require more work as it’s more active or “hands on.” To aid investors both Prosper and Lending Club have introduced automated tools that allow for selection and purchase of loans that meet a predetermined criteria. This not only reduces the burden of loan selection, but also helps ensure that any idle cash is quickly put to work and doesn’t drag on returns. Along with automated investing they also utilize Folio as a secondary market for note trading. The presence of a secondary market doesn’t necessarily mean the notes are highly liquid. There still needs to be demand for a given loan or you may get taken to the cleaners.

Fees certainly deserve some consideration as well. According to their respective prospectus documents Prosper and Lending Club currently charge 1% of the outstanding loan principal, and Prosper has a provision to charge up to 3%. That’s pretty steep compared to a passive index fund, but somewhat reasonable when you account for the high interest rates charged to borrowers. Being that loans are a form of fixed income (i.e. a bond) the interest received is taxed as regular income and thus a very tax inefficient way to grow money. Both Prosper and Lending Club offer IRA accounts to help improve the tax consequences. However, IRAs on these platforms are managed by a third party institution–Self Directed IRA Services for Lending Club and Sterling Trust for Prosper). SDIRA charges a $100 annual fee which Lending Club pays if you maintain a $5000 balance during the first 12 months and $10,000 thereafter. Prosper has a nearly identical arrangement with Sterling Trust for it’s IRA accounts.

On the subject of returns there are two primary arguments that I’ve heard used to justify the high interest rates. The first claims that these new online platforms are eliminating the “fat” found in commercial lending institutions–providing lower rates to borrowers than could be achieved elsewhere. The second is that high interest rates are a compensation for a very real risk–the possibility that loans won’t be paid and may end up in default. Which answer is correct? I have no idea, but I can’t help but think it may be a combination of the two. Until more is known I wouldn’t treat these notes as part of the safe, fixed income portion of my portfolio. I also wouldn’t be surprised to see defaults increase and portfolio returns decline should we enter a recession. I further expect that interest rates on these loans will behave in the same way as other fixed income securities. Furthermore as we enter a rising interest rate environment the rates charged on newly issued loans should begin to increase as the Federal Reserve increases the Federal Funds Rate.

As the space has grown in the past few years a number of investors and personal finance folks have been writing about their experiences and even disclosing their returns
Mr. Money Mustache: MMM Lending Club Experiment
White Coat Investor: Earning 13% With Peer To Peer Lending
Lend Academy: My Returns at Lending Club and Prosper

Sites such as Lending Memo and Lend Academy are some other great resources available for investor education
Lending Memo: Peer to Peer Lending Sites: An Exhaustive Review
Lend Academy: Investor Resources
Lending Club Review for New Investors Review for New Investors

The growth of these two companies has been massive in the past few years and it will be interesting to see how well they do. I have a provision in my investment policy statement that allows me to invest a small percent of my funds in alternative assets such as these loans. Currently I’m considering a small taxable fund to learn more about the inner workings of this space. If it does well I may consider increasing my holdings through a tax advantaged Roth IRA.

Lending Club

What I’m Reading
Buy What You Love: A Smart Financial Decision (Behavior Gap)
What I learned by not drinking for 2 years (Chicago Tribune)